Financial gearing measures the relative amount of debt in a firm's capital structure.
Gearing is sometimes also known as leverage.
Gearing and leverage ratios can be calculated in several different ways, so consistency of approach is important.
Two essential bases to define are:
i. The use of book or market values.
ii. The use of Debt divided by Equity (D/E) or of Debt divided by Debt plus Equity = D / (D+E).
Assume the values of debt and equity are equal, say USD 1m each.
D/E = 1/1 = 100%.
This is usually known as 'gearing'.
Using the other calculation with the same inputs (D = 1 and E = 1):
D / (D+E) = 1/2 = 50%.
This is usually known as 'leverage'.
Adjustments to D and E figures
With respect to the Debt figure, practice varies in including or excluding certain items such as cash, short term borrowings, leases, pensions and other provisions.
Practitioners may also adjust the Equity figure, for example to exclude intangible assets.
Operational gearing relates to the operating costs of a business, and measures the relative proportions of fixed and variable operating costs.
'Gearing up' refers to increasing the levels of financial or operation gearing - or both - within an organisation.
The intention of gearing up is to improve expected net results.
A consequence of gearing up is normally to increase risk.
Many financial disasters have been a consequence of gearing up (or leveraging) excessively in this way in earlier periods.
- Debt equity ratio
- Debt to equity ratio
- Intangible assets
- Leveraged takeover
- Off-balance sheet finance
- Ungeared cash flow